Gasoline Prices: Why So High, and What to do?

Once again, high gasoline prices are in the news. As of this writing, the national average gasoline price per gallon price is hovering around $3.79. The price pinch at the pump is sparking consumer and voter discontent. SymphonyIRI reports, “57 percent of consumers are feeling increased financial strain when gas prices increase, and more than four in ten say high gas prices make it difficult to meet monthly expenses,” based on polls conducted in the second quarter of 2011. Further, 49 percent of consumers plan to reduce grocery spending if gas prices climb another 50 cents. An Associated Press-Gfk survey conducted February 16-20, 2012, found that 58 percent of respondents disapproved of how President Obama has handled gas prices. On March 6, 2012, or “Super Tuesday,” seven out of ten primary voters said gas prices were an “important” factor in their decision making.

So what’s behind gas prices?

Oil Supply and Demand

The primary reason for high gasoline prices, as any economist will tell you, is very simple: world demand for oil is strong, and the supply is limited. The cost of crude oil dominates the price of gas: in January 2012, it represented 76 percent of the price.

Risk also influences the world price of oil. Unrest in the Middle East is a perennial cause of worry over world oil supplies, and explicit threats by Iran to close the Straits of Hormuz can’t be promoting confidence in oil consumer markets.

Another source of supply uncertainty is the moratorium that the Obama administration has slapped on U.S. development of domestic oil production in the last two years. Since the Deepwater Horizon oil rig disaster in 2010, U.S. domestic oil production has slowed significantly, especially in the Gulf of Mexico. The permitting slowdown as a result of the spill is estimated to have cost the United States $4.4 billion in output costs, 19,000 jobs, $1.1 billion in wages, and over $500 million in federal, state, and local government lost tax revenues.

Taxes

The tax bite in a gallon of gasoline is nearly equal to the costs of refining, distribution, and marketing combined. That fluctuates, of course, because most gas taxes are percentage based. At $3.79/gallon, taxes account for about 53 cents.

A Fractured Market

In order to fulfill air pollution reduction plans in states and localities across the country, gasoline sold in the United States has been fractionated into about 17 different boutique fuels sold in dozens of discrete markets. With three grades of gasoline per fuel, refiners are producing over 50 separate blends. Such boutique fuel requirements both increase price volatility and the height of price spikes as a function of the distance-to-market of boutique fuel producers and consumers, according to the Energy Information Administration.Boutique fuel requirements also increase the absolute price of gasoline sold in boutique markets, according to the U.S. Government Accountability Office.

Escalating Refinery Costs

Another factor contributing to the increased price of gasoline is the reduction in the number of operating refineries in the United States over the last 30 years. The number and capacity of U.S. refineries peaked in 1981, and, since then, 171 plants have closed, although the remaining plants have increased output to offset a loss of production. Though most of this reduction has been caused by the low profit potential of refineries, but others see a significant cause in “extremely tight environmental restrictions, not-in-my-back-yard community opposition, and the high cost of new construction.” Refinery profit margins have played a role in recent gasoline price hikes. The EIA suggests that “The sizable jump in retail prices this year reflects not only the higher average cost of crude oil compared to previous years, but also an increase in U.S. refining margins on gasoline (the difference between refinery wholesale gasoline prices and the average cost of crude oil) from an average of $0.34 per gallon in 2010 to $0.45 per gallon in 2011 and $0.42 per gallon in 2012.”

A Weak Dollar

In recent congressional testimony, Robert Murphy, of the Institute for Energy Research observed: that: “From its peak in March 2009, the dollar has fallen 17 percent against other major currencies. Therefore, holding everything else constant, the dollar depreciation alone from early 2009 can explain a 20.5 percent increase in oil prices (quoted in dollars)....It is on the basis of such calculations that a recent Joint Economic Committee report estimated that Federal Reserve policies have added almost 57 cents to the price of a gallon of gasoline for American motorists.

But what about those speculators?

While speculation has been shown capable of causing short term-price spikes in the past, Cato Institute scholars Jerry Taylor and Peter Van Doren show there is little evidence that speculation is a cause of oil price hikes since 2005. They find that rather than increasing price volatility, it turns out that speculation increases after price volatility manifests, and tends to damp it down: only two out of 26 studies of speculation they surveyed showed increased price volatility after the onset of futures trading in commodity markets, while 14 out of 26 studies showed a decrease in commodity price volatility after trading markets were introduced.

Understanding what goes into the price of gas is key to understanding what the government could do to lower gasoline prices. Contrary to the claims that the president can’t do much to lower the price of gasoline, rapid-response options include implementing tax holidays; relaxing/waiving boutique fuel requirements that fragment markets; and relaxation, suspension, or simplification of environmental regulations raise refining costs. Longer-term options include increasing domestic production, strengthening the dollar, and sending coherent policy signals that might reduce perceived risks to world oil market stability.

Kenneth P. Green is a Resident Scholar at the American Enterprise Institute. This column is derived from “Why are Gasoline Prices High (And What Can be Done About it?)